How are Mortgage Rates Determined????

To dive a little further into the factors that drive mortgage rates one should take a step back and examine how the value of a bond is determined.

All interest rates are determined relative to what is considered to be the real risk free market interest rate if no inflation were expected in the future. This real risk free interest rate, which most consider to be the 90 day US Treasury bill, is the benchmark for how other market rates are determined.

Unfortunately the majority of interest rates are not risk free; there are other factors that go into determining what the money you invest NOW will be worth in the FUTURE. This is the concept of "The Time Value of Money".

When placing a present value on your future cash flows you must consider several risks...these risks correspond to what you expect to receive in return from investing funds. That said, going back to how interest rates are determined...

Remember all rates are based off of the "risk free" benchmark interest rate. On top of that, to compensate for unexpected and expected risks, investors will demand additional returns based on the following...

1. Inflation Premium: If you invest $10 today and you expect the value of a dollar to be worth less tomorrow, then logically you would expect to be compensated for the loss of the principal investment. To make up for the loss of cash flows You will therefore demand a higher rate of return (interest rate). When inflation is expected to go up then interest rates go higher to compensate for the lost value of your principal investment.

2. Default Risk Premium: this portion of an interest rate is based off of the possibility that the person or company you are lending money to may not be able to pay you back. That is what a bond is after all, you are lending money to someone else , and in return you receive interest rate plus principal (original money you lent).

US government bills, notes, and bonds have a low default risk premium because they are backed by the full faith and credit of the United States Government.

On the other hand....subprime mortgage loans have a high default risk premium because there is a higher probability that those borrowers will default on their loan. At least compared to a borrower who qualifies with strong credit and stable income.

3. Liquidity Premium: If an investment cannot be easily turned back into COLD HARD CASH it is said to be illiquid. The liquidity premium is based off the market's demand for the specific type of debt (bond) you hold or  are attempting to issue. There is massive demand for US debt (bills, notes, and bonds)...if you wanted to sell your holdings of these securities it would be easy to find a buyer. If you hold the debt of lets say a smaller, not widely recognized company, it would likely be harder to find a willing buyer of that debt because of a lack of transparency regarding the firms financial well being. When it is hard to find a buyer the seller must lower the price enough to attract willing buyers. This is said to be an illiquid security.

4. Maturity Premium: This compensates an investor for how long their money will be tied up in an investment. The longer the length of the bond contract (longer maturity) the more time there is for economic conditions to change.

That means that, given a longer time frame, all of the previously discussed premiums have a higher likelihood of being worse (or better) at the time of maturity. For example inflation expectations may change or the ability of the debt issuer to service their loan may be lost...and your investment will be worth less.

This explains why the yield curve of US Treasury bills, notes, and the bond is generally sloped upward. The clarity of economic expectations defines the maturity premium.

So to put all this together...

Interest Rate = real risk-free interest rate + inflation premium + default risk premium + liquidity premium + maturity premium

NOW to relate to all this to mortgages...In the most simplistic of explanations....the pricing behavior of a bond is as so : When there is more demand for a bond, meaning more buyers than sellers, the price of the bond goes up. When the price of a bond goes up the yield goes down until supply and demand reach equilibrium again (and vice versa).  To oversimplify this happens because the price of the bond eventually becomes too expensive relative to the return that is received (the interest rate).

Although mortgage rates act similar to US bills, notes, and bonds....they do not operate the exact same way. Allow me to give some background first. The majority of mortgages that are sold in the US end up being securitized in some way or another. Usually they are put together in big groups of loans with similar interest rates and loan characteristics. Those pools of loans have a specific cash flow tied to them based on the average interest rate (coupon) of the mortgages that make up (back) the pool. When investing in that pool of mortgages, because you know what the average coupon rate, you know how much money you will get paid and when you will receive these cash flows. This is a broad description of mortgage securitization, or how your mortgage becomes part of a mortgage backed security (MBS).

Now that you have some MBS foundation lets build on it. How are the rates you are offered determined?

When economic conditions change or one of the above premiums changes these pools of mortgages either gain or lose value, meaning they become worth more or worth less. When those pools change value so do the interest rates you  are offered when you seek to refinance or purchase a home. Here's how: Every morning lenders publish a rate sheet and distribute it to loan officers who then offer  you an interest rate. Depending on the time these rate sheets are generated, rates will either be better or worse based on the price the MBS pools are trading at when rate sheets are generated (more so dependent on when lenders locked (sold forward) their supply of loans).  If "rate sheet influential" MBS are being bid up (price increases) mortgage rates will most likely be set lower compared to the previous day.  If "rate sheet influential" MBS coupons are selling off, the mortgage rate you are quoted will likely be higher than the previous day. 

Here is where things get a little more complicated. If the MBS prices go up and stay up, mortgage rates will move lower and lower (to a point where primary/secondary spreads can no longer tighten). If mortgage rates move lower there may be enough incentive for you to refinance your home. When refinance you are paying off your old mortgage and getting a new one with a lower interest rate, which restarts the securitization process. But here is the thing...the bank, money market manager, pension fund, insurance company, hedge fund, or servicer that invested in the pool of MBS that your loan partially backs then loses the cash flow that you contributed when you made your monthly payment (because you prepaid/paid off your loan early).  This is the big difference between mortgages and other types of bonds like the 10 yr US Treasury....an  MBS investor knows about how much cash flow they will receive and when they will receive it, what they don't know is  how long the cash flow will last due to the fact that borrowers have the ability to refinance their loan at any time (when they have incentive or need). This additional risk associated with mortgages is called prepayment risk, the option to refinance is an  "embedded call option" within the mortgage-backed security.  Prepayment risk adds a feeling of uncertainty to MBS investors, it distorts a portfolio managers ability to determine the present value of the expected future income streams that are generated from pools of mortgages, especially when interest rate volatility increases.

When rates are expected to be lower in the future, well I should say low enough to provide incentive to refinance or purchase, the pools of mortgages (MBS) that are backed by loans with higher rates will begin to lose more and more value as rates go lower and more borrowers refinance their loans (they prepay their loan or use their call option). Remember the income MBS investor expect to receive is generated when you pay your monthly payment, so if you refinance your loan MBS investors lose the income stream they were expecting you to contribute to the MBS pool. MBS investors therefore must find a way to replace that lost expected future cash flow.  If a group of MBS investors believes rates will go lower then they may sell a portion of their higher interest rate (fuller) MBS portfolio in favor of lower rate pools to compensate for lost income (and need to extend duration of their cash flows if yield curve is flattening). They do so because they believe they will receive stable cash flows for a longer period of time (relative to liabilities..that is the investor must offset cash inflow duration with cash outflow duration).

How does this affect day to day mortgage rates?

When the yield curve fluctuates, a shift in coupon bias (duration bias) generally follows. This can result in either buying or selling "down in coupon" (when yield curve flattens) or "up in coupon" (yield curve steeper). Often times when selling a pool of MBS made up of mortgages with higher interest rates, investors will look to buy pools secured by loans with lower rates to stabilize their expected future cash flows. This is called a down in coupon day and is a major force in the daily price movements of mortgage backed securities. The same happens on up in coupon days but in that case MBS investors sell "rate sheet influential" MBS coupons and mortgage rates generally move higher.

To summarize when reading our commentaries you should understand that when we say prices of mortgage backed securities (MBS) are going up, that the rate you are offered as a borrower will go down. The MBS is subjected to the same premiums that determine the value of other types of bonds, except MBS are exposed to prepayment risk, the fear that an investor may lose future cash flows because a mortgage holder (borrower) decides to refinance their home.  This additional risk often forces portfolio managers to extend the duration of expected future cash flows by either buying lower coupon MBS pools or perhaps purchasing less risky securities with more relative value. In times of economic uncertainty and increased interest rate volatility, forecasting the expected interest rate environment becomes a difficult task. Therefore the models used to determine the future value of cash flows generated by a pool of mortgages become inaccurate.  This creates a volatile interest rate market and often times confuses borrowers as the why mortgage rates sometimes fluctuate in a wide range.